This post was written by Dusty Elias Kirk and Peter H. Schnore.
[This article was originally published in the June 2012 issue of the Institute for Professionals in Taxation Tax Report.]
On April 25, 2012, the Pennsylvania Supreme Court handed down its much-anticipated decision in Tech One Associates v. Bd. of Prop. Ass’t. of Allegh. Co. At issue in Tech One is the effect of a ground lease on taxation of real property in Pennsylvania.
The questions addressed by the discussion in Tech One are:
- Is a building constructed on a property subject to a ground lease subject to real estate taxation? Answer: Yes
- Does the “economic realities test” still apply? Answer: Yes
- Does the income approach apply to both the land and building if subject to a lease? Answer: Yes
In Pennsylvania, assessors typically arrive at values for both land and building; with limited exceptions, however, these values are combined. As a result, one taxpayer – the owner of the land – receives the annual property tax bills. Instances where the landowner and building owner receive separate assessments and tax bills are a very rare exception to the general rule, and in many cases require obtaining a formal subdivision. Moreover, even though there is one assessment for land and improvements, Pennsylvania judicial law is clear that an appeal cannot be filed as to either the land value or the building value alone – the values of both aspects of a property are at play when an appeal is filed.
In Tech One, the Pennsylvania Supreme Court addressed the manner in which real property subject to a long-term ground lease should be taxed. The court declared that the value of improvements must be included in a property’s assessment, regardless of whether they are owned by the landowner or are constructed by a lessee pursuant to a ground lease. Including the value of both land and building in a property’s assessment may sound intuitive, unremarkable, and in fact, necessary in order to uniformly assess the subjects of taxation; but it represents a paradigmatic shift from the way many such properties were valued in Pennsylvania since the early 1990s.
This decision raises new questions, however, regarding who, between a property owner and tenant, is to be taxed, who has the right to file an appeal, and whose interests are to be subject to a municipal lien if those taxes are not paid. These questions include: How are properties to be assessed when the ownership of the land and building are different, when under Pennsylvania law, the record owner of the property is responsible for the entire tax bill? How will collection of taxes be affected, if a building owner has one value and a land owner another? Whose property will be liened if taxes are not paid? Will this concept of valuing leased-fee and leasehold interest be extended and adopted in a fact situation that does not involve a ground lease?
In order to appreciate this shift in the law, it is worthwhile to review where Pennsylvania law was (and in important respects, still is) before the Supreme Court handed down Tech One.
The Development of the Law In and After Marple I
In 1992, the Pennsylvania Supreme Court expanded its application of the “economic realities” test to the conventional commercial setting in In re Appeal of Marple Springfield Shopping Ctr., Inc., 607 A.2d 708 (1992) (“Marple I”). In Marple I, a property owner entered into a lease with a commercial tenant for anchor space in a shopping center. Under the lease, which contained options to extend it for 56 years, the rent remained constant at $1.47 per sq. ft. By the late 1980s, the tenant was subletting its leasehold for more than double what it was paying to the property owner. Significantly, the property owner maintained the obligation to pay the real property taxes. The Supreme Court addressed whether the long-term restriction on rent should be considered when determining the property’s assessment. It concluded that the “economic realities” were such that the property’s assessment should account for the long-term, below-market rent, because the arm’s-length, long-term lease negatively affected the market value of the property. The Marple I court concluded that “[t]o interpret the tax assessment statute as requiring valuation of property in hypothetical “unencumbered form” . . . is to ignore the economic realities of commercial real estate transactions. Marple I at 710.
The Pennsylvania Commonwealth Court (an intermediate appellate court between the trial courts and the Pennsylvania Supreme Court), believing that it was following the economic realities test as described in Marple I, addressed cases involving long-term ground leases where improvements were constructed pursuant to the ground lease.
In In re Appeal of Marple Springfield Ctr., 654 A.2d 635 (Pa. Commw. 1995) (“Marple II”), the Commonwealth Court concluded that the value of an appliance store that the lessee constructed on the land subject to the same lease at issue in Marple I (and the income stream attributable to that new store) should not be included in the property’s assessment, because the underlying landowner received no additional rent as a result of its construction.
Similarly, in In re Assid, 842 A.2d 995 (Pa. Commw. 2004), the property owners leased a 339-acre tract of land under a 30-year lease. Pursuant to the lease, the lessee constructed an 18-hole golf course on 100 acres of the property, the annual rent being $60,000 or 10 percent of gross profits from the operation of the golf course, whichever was greater. The property owners challenged a revised assessment, and contended that the value of their property should be based not upon the improvements constructed upon the property, but upon the income stream received under the ground lease. Reversing the trial court, and citing Marple I, the Commonwealth Court found in the property owner’s favor.
Armed with the Marple II and Assid decisions, landowners whose land was subject to long-term ground leases were arguing, often successfully, that the assessment of the property should be limited to a capitalization of the net income received in ground rents, regardless of the value of improvements on the property; regardless of which party – the landowner, the building owner or a combination of the two – paid the property taxes; and regardless of who, between the landowner and lessee, owned the improvements.
The Facts of Tech One and the Lower Courts’ Decisions
The subject of the tax assessment appeal underlying Tech One is a 47.5-acre property in a suburb of Pittsburgh, Pennsylvania. The appellant purchased the undeveloped property in the 1980s. In 1989, it entered into a 50-year ground lease for the entire 47.5 acres. Pursuant to the lease, the tenant constructed a 415,000 sq. ft., 29-unit strip shopping center, a free-standing movie theater, a restaurant, and parking lots, upon the land. The lease gave the tenant the right to convey the improvements at any time during the lease. The lease also contained a purchase option, whereby the lessee could purchase the property in the 49th year of the lease. The lease required the lessee to pay $665,000 annually for the entire term of the lease, and to pay all real estate taxes on the premises.
The property owner appealed the assessment to the Allegheny County Board of Assessment, Appeals and Review, which established the assessment at $30,984,700 for 2001 and $32,470,300 for 2002. The property owner appealed the Board’s decision to the trial court, which held an evidentiary hearing. Utilizing the income approach, the taxing jurisdictions’ appraiser calculated fair market values for the property by capitalizing the net operating income derived from the ground rent, and added to it the value of the leasehold, which he calculated by capitalizing the net operating income achieved by the tenant through its leasing space in the buildings. He arrived at fair market values between $31 million and $36 million for each year at issue in the appeal. The landowner’s appraiser arrived at an opinion of value of $9.5 million for all years at issue based solely upon the ground rents, and contended that this was the appropriate way to value the properties in accord with the Marple line of cases. However, the property owner’s appraiser also testified that he had assigned values of between $11 million and $15.5 million for the improvements for each year at issue, despite those figures not appearing in his appraisal report. The trial court issued a written opinion in which it stated, among other things, that to assess property upon ground rents alone would cause similar properties to be taxed in significantly disparate ways, such that it violates the Uniformity Clause of the Pennsylvania Constitution. The trial court adopted the values of the taxing jurisdictions’ appraiser, which resulted in assessments between $31 million and $36 million per year.
The property owner appealed the trial court decision to the Commonwealth Court. The Commonwealth Court issued a published opinion, Tech One Assoc. v. Bd. of Prop. Ass’t., App. and Rev., 974 A.2d 1225 (Pa. Commw. 2009), in which it affirmed the trial court’s decision. It reconciled the Supreme Court’s holding in Marple I, and its holdings in Marple II and Assid, by concluding that because the lessee paid the property taxes in Tech One, the “economic realities” were such that the value of the improvements should be subject to taxation.
The property owner filed an application for permission to appeal to the Pennsylvania Supreme Court, which granted the appeal to address two issues: First, whether the “economic reality test” announced in Marple I applies to establish the value of property encumbered by a long-term lease where the lessee owns the improvements; and second, whether the Uniformity Clause of the Pennsylvania Constitution requires an improved property encumbered by a long-term lease to be taxed in the same manner as similar but unencumbered property.
The Supreme Court’s Take in Tech One
The Supreme Court summarized the applicable tax-enabling statute, the Marple line of cases, and the decisions of the courts below. It declared that under the legislation that enables the taxation of real property, the manner in which real property is owned is irrelevant: All real estate enumerated in the assessment statute that is not otherwise exempt, is subject to taxation. The Tech One court stressed that the assessment of all improved real property must account for all of its components – land and improvement – and value it as a whole.
The court noted that the Commonwealth Court read too much into Marple I when it issued its Marple II and Assid decisions. The Tech One court declared: “Nowhere in [Marple I] did we suggest, however, that, in valuing taxable property as a whole, the value of any portion which is owned as a leasehold interest could be disregarded. . . . We expressly disapprove of any contrary conclusion expressed or suggested in the Commonwealth Court decisions of [Marple II] and Assid.” It also declared that the court’s “holding in [Marple I] simply necessitates that . . . the impact of the lease on the market value of the real estate owned as the leased fee and, also, on the market value a leasehold interest must be considered.”
Because it concluded that neither “the General County Assessment Law, nor our previous decision in [Marple I], permits real estate to be classified differently for purposes of taxation based upon the manner in which it is owned,” the Tech One court concluded that it did not need to address the constitutional uniformity question.
The Tech One court, however, underscored that the income approach remains “the most appropriate if not the only valid means” to value income-producing property for tax-assessment purposes. It also reiterated that the effects of long-term leases cannot be ignored, whether the assessor is valuing the leasehold or the improvements constructed pursuant to the lease. Accordingly, for the purposes of valuing both the leased fee (land) and the leasehold (improvements), which is often itself the subject of subleases, the income approach remains one way, if not the only valid way, to arrive at the appropriate assessment of the property.
Practitioner’s Note: The ‘Economic Realities Test’ Remains Alive and Well
After Tech One, improvements constructed and owned by a tenant pursuant to a ground lease must be valued for real estate tax purposes. From a practical standpoint, the value of this leasehold now may be greater than the value of the land based on the ground rent or, vice versa, based on the age of the structure and other factors. Assessors will now need to determine how to assess these interests under Pennsylvania law. It is certainly not clear if assessors will know how to properly apply the economic realities test in this context. It will now be incumbent on drafters of leases to make it clear how the taxes are going to be allocated between land and building. Practitioners may also want these provisions recorded in a memorandum of lease so that in a sale of either the land or the building, the responsibilities of each entity are clearly defined.
Additionally, as a practical matter, most ground leases provide for some kind of allocation of taxes between land and building, and this allocation is often not directly related to the leasehold estate. For example, a tenant may pay a pro rata share of taxes attributed to the parking area and the entire tax on the building it leases. In most instances, the landlord collects any taxes due from the tenant under the lease agreement and is responsible for sending these taxes into the tax collector. In effect, the landlord has a contract right to collect the taxes due from the tenant. Tech One does not address what is to occur when the tenant fails to pay its portion of the taxes to the landlord, but where the landlord’s property rights may be subject to a tax sale for unpaid taxes under Pennsylvania’s Municipal Claim and Tax Lien Law. Landlords must now address this issue in their leases and in recording instruments. Query whether another appellate court case will also be needed to address the landlord’s rights in a tax sale situation where the landlord paid the taxes attributable to the land’s assessment, but where the taxes attributable to the improvements constructed pursuant to a ground lease were not paid.
In Pennsylvania, it appears that it will take other Supreme Court decisions for practitioners to know the answers to these questions. In the meantime, landlords and tenants alike are advised to closely examine their leases for responsibility of tax payments and tax liens.